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Where is China in the Sentiment Cycle?

China has been headline news once again following the mini-devaluation of its currency as the government attempts to prevent its economy slowing further; volatility in financial markets has risen, but what happens now and how should investors react?

19/10/2015

Malcolm Melville

Wealth Preservation Manager

Source: Schroders. For illustrative purposes only.

China’s Sentiment Cycle

According to latest figures growth in China is slowing. Given China is the world’s second largest economy and global growth remains sluggish at best, investor uncertainty has risen and as a result markets around the globe have corrected.

As an investor, deciding on your next move can be difficult, will markets rebound or continue to fall? Is the worst over or is there more pain to come?

In times like these, crunching the numbers and looking at the economic data can be useful, but if the numbers only reflect reality it can be hard for investors to make a decision.

We are avoiding Chinese assets and other assets which are dependent on the Chinese economy.

China in “Out of Fashion” was characterised by the Tiananmen Square protest of 1989, the 1993 devaluation and the Asian crisis in 1997.

The evolution of China’s economy

Since then the economy has changed beyond recognition, as the reforms of the 1990s started to pay dividends, enabling the move into “Early Adoption”.

The strong growth between 2002 and 2007 allowed China to move through the positive sections of the Cycle.

Faith in the economy’s ability to withstand shocks was cemented with the rapid recovery following the Global Financial Crisis (GFC).

The successful navigation of a crisis is often the last event before entering “Blind Faith”. Investors started to accept Chinese growth forecasts as fact, without question.

They have forgotten it was the reforms of the 1990s that set the stage for the years of prosperity and not a new found ability to generate growth by saying “GDP will be 7%”.

Investors have yet to give up on China completely and importantly it needs to spend time in 'Out of Fashion' while the excesses are unwound.

This “Blind Faith” conditions investors to ignore the warning signs, such as the build up in credit (which generated the post-GFC recovery), until asset prices fall too much to be ignored.

Commodities were the first asset to respond to Chinese economy weakness and moved investors into the “Acknowledgement” area.

However, it was not until the stockmarket fall in mid 2015 and the mini currency devaluation of August this year that investors recognised fundamentals have changed.

Where next for China?

The stages of the Cycle are proportional to each other in time, although there is no exact relationship.

China took 10 years to move from “Out of Fashion” to “New Paradigm” and has since taken seven years to reach “Acceptance”.

Investors have yet to give up on China completely and importantly it needs to spend time in “Out of Fashion” while the excesses are unwound.

We are avoiding Chinese assets and other assets which are dependent on the Chinese economy.

This can be achieved quickly with bankruptcies and reform, or much more slowly by propping up failing institutions with endless supplies of new credit.

The latter is less harmful in the short-term and is probably more politically acceptable but will be painfully slow. Whichever route is chosen, from a sentiment perspective, China is not out of the woods yet.

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